Inflation, the Underrated Destroyer of Prosperity

In my last video message on monetary issues in January, I ended by saying that I would talk about the Bank of Canada’s inflation target in the next one. For all kinds of reasons, including the many speeches that I gave in the meantime, I was not able to do it. However, this is the topic I discuss in a speech delivered at the Economic Club in Toronto this morning.

Monetary policy is one of the most difficult topics in economics. But also, I believe, a topic of absolutely crucial importance for our prosperity.

As you all know, last week, the Bank of Canada increased its benchmark rate by a quarter of a percentage point to 0.5%. There had been a lot of speculation in recent weeks about that decision to finally raise rates after keeping them at a record low for more than a year. And as usual there will be a lot of speculation about the bank’s next moves. How far will it go? How fast?

All this guessing about setting rates has nothing to do with capitalism and free markets; it has more to do with central planning and government control of the money supply. In a monetary free market, the interest rate would be determined by the demand for credit and the supply of savings, just like any other price in the economy.

Government control over money has serious consequences that few people seem to be aware of.

One of them is that central banks are continually increasing the quantity of money that is circulating in the economy. In Canada for example, if we use the strictest definition of money supply, it has increased by 6 to 14% annually during the past dozen years. The situation is about the same everywhere.

The effects of constantly creating new money out of thin air have been a debasement of our money and a dramatic increase in prices. The reason why overall prices go up is not because businesses are greedy, or because wages go up, or because the price of oil goes up. Ultimately, only the central bank is responsible for creating the conditions for prices to rise by printing more and more money.

The Bank of Canada has had an inflation rate target of 2% for more than 15 years. A price inflation rate of 2% a year may seem small. But when you add up 2% of depreciation of the monetary unit year after year, you end up with large numbers. Total inflation in Canada from 1990 to today adds up to 45%. This means that your dollar can now buy the equivalent of less than 70 cents if you compare it to 20 years ago.

As even the Federal Reserve chairman Ben Bernanke admitted, inflation is the equivalent of a tax. The most insidious of all taxes, which bears hardest on those least able to bear it. It eats away at our purchasing power, our revenues and our savings.

It is true that most of us get salary increases that compensate for the loss of purchasing power. But all those whose income doesn’t increase as fast as prices get poorer.

Many interest groups, including governments, like cheap credit. There is an inherent bias in monetary policy in favour of lower interest rates. But this too has unwelcome consequences.

One of them is that people are encouraged to save less, because the returns on savings are lower. And they are led to carry more debt, because credit is easier to obtain.

This is precisely what we have been doing in Canada, in the U. S. and elsewhere in the world for the past 20 years. In 1990, the ratio of total debt to disposable income for Canadian families was 90%. Today, this ratio has gone up to 144%, an all-time high.

It seems that debt has become a way of life. Thankfully, public debt in Canada is at a reasonable level. But as we are seeing around the world, many countries such as Greece are now on the brink of bankruptcy because they became too dependent on cheap money.

Monetary inflation creates all kinds of market distortions and is also the cause of the booms and busts that our economy has been going through.

The pattern is becoming sufficiently clear that these are not an inherent failure of the capitalist system as many people believe. They are rather caused by central bank policies, as economists such as Nobel Prize winner Friedrich Hayek explained long ago.

Remember: we had the dotcom bubble at the end of the 1990s. When that crashed, Alan Greenspan flooded markets with money. Between 2001 and 2004, the Federal Reserve pushed down interest rates to as low as 1%.

If you factor in the level of inflation, real interest rates were actually negative. This is the same as subsidizing people to encourage them to take loans. But we all know this lesson: you cannot live on a credit card for very long!

We then got another bubble, which was made bigger by the policies of the U. S. government. It encouraged banks to extend risky mortgages to insolvent borrowers; and it encouraged people to take up these mortgages and buy houses that they could not really afford.

You’ve heard the rest of the story. These mortgage loans were securitized and then sold on the market around the world. And the financial institutions that had bought them got into trouble when home owners started to default and home prices went down.

In 2007, that real estate bubble too began to burst. And since then, central banks have once again sent interest rates down to almost 0%. This means that real interest rates are again negative, since price inflation is higher than that. Central banks have flooded the financial markets with money and allowed governments to pile up gigantic amounts of debt to prevent a recession.

It is true that economic growth seems to be back. But how sustainable is it? How will governments and households reimburse all this debt, unless they cut back on spending? Will some countries decide to monetize their debt and thereby provoke high inflation? Have we created more bubbles in new sectors that will bring another global recession down the road when they burst? If this happens, what kind of stimulus policies will we be able to adopt if we are drowning in debt?

Despite all these negative effects of inflation, most economists and commentators seem to think that a little inflation is a good thing. And they tell us that deflation, or a fall in prices, would be a disaster for the economy. But that’s not true.

Let’s start with common sense and what’s happening in our daily lives. Do you, as consumers, prefer to buy stuff that is cheaper or more expensive? I think we all know the answer to that!

We are all consumers, and we all benefit when prices go down. If we pay less for one good, it means we have some money left to buy other goods.

Economic activity does not stop. It simply means we can buy more with the same amount of dollars. And more purchasing power means a higher standard of living for everyone.

In fact, there is nothing mysterious about the effects of lower prices. Think about computers. Fifteen years ago, they were big, not very powerful, had few gadgets, and cost a lot more than today. Prices in the computer business have been going down all the time since then.

Have people stopped buying computers or waited years before buying a new one to benefit from even lower prices? Absolutely not. On the contrary, more computers are being sold as their prices go down.

Imagine a situation where central banks don’t manipulate the money supply anymore. And instead of continually rising at a rate of between 6 and 14% per year, as we’ve seen in Canada in recent years, the quantity of money in the economy remains stable.

Every year however, we become a little bit more productive. We create new goods and services. We find new methods to produce them more efficiently. Technology gets better. And if there is population growth, there are also more people working.

So there are always more and more goods and services available in the economy, but we have the same quantity of money to buy them. Prices will obviously have to adjust by going down. If the economy grows, let’s say, by 3% a year, while the money supply grows by 0%, then we will necessarily get price deflation.

Note that in this context, businesses are still able to make profits, because their costs also go down.

This is not just theory. It is what happened several times in the 19th century, in an era of rapid economic development. At a time when there were no central banks and when money was calculated as a certain quantity of gold or silver.

Deflation is not a threat to our prosperity. On the contrary, in a situation where the money supply is stable, it is the manifestation of prosperity!

Prosperity has nothing to do with the quantity of money that we have in our pockets, but rather with the quantity of goods that we can buy. And if we can buy more goods with the same amount of money because prices are lower, then we are more prosperous.

This is why there is no reason to fear a drop in prices. And why the interventions by central banks to prevent prices from going down causes more harm than good to the economy.

Now, given all this, what should we do? I believe that within a few years, we will need to hold a serious debate about returning to the gold standard.

Until then however, there are more immediate measures to discuss, such as the inflation target of the Bank of Canada. The agreement on the price inflation target between the Bank and the minister of Finance is set for five years and has to be renewed next year, in 2011. The Bank is studying different alternatives to the current 2% target.

I’m very happy that the Bank has already rejected a suggestion made in a report by the International Monetary Fund last winter, to increase the target rate to 4%. The IMF logic is entirely based on the idea that central banks should have more flexibility in trying to manipulate interest rates and the amount of money in circulation. According to this view, higher inflation and borrowing costs at the outset of a crisis would allow central banks to slash interest rates more aggressively and keep them at lower levels longer if needed to encourage spending.

That’s like trying to cure a drug addict with larger drug injections. The problem is precisely that there is already too much inflation and too much manipulation of the money by central banks. The solution has to be to reduce them, not increase them.

Another one of the proposed alternatives is to target a price level over a longer period instead of an inflation rate every year. This means that if one year for example, the inflation rate is 1%, then the next year the Bank would try to increase prices by 3%, instead of trying to simply go back to its goal of 2%. It would target an average rate of inflation over time and compensate for past deviations by deviations in the opposite direction.

Let me rephrase this differently from my own perspective. The inflation rate was only 1% last year. We should have debased the currency by 2% to reach our targeted price level. So this year, let’s create even more money out of thin air so that it loses 3% of its value. This will compensate for last year’s insufficient debasement of our dollar.

Sounds absurd? I think it is too.

If we have to have an inflation target, I believe the best and most realistic alternative at this point would be to set it at 0%. It is true that this would diminish the ability of the Bank of Canada to artificially stimulate the economy. There could not be negative real interest rates as we have now, since the Bank’s official interest rate cannot go below 0%. But as I said, I think that too much monetary manipulation is the problem, not the solution.

The Bank would need to have a much more prudent and sound monetary policy to keep price inflation at 0%. That would really preserve our purchasing power. That would help prevent the cycles of booms and busts that we have experienced. It would reduce the price distortions that inflation causes throughout the economy. It would facilitate the financial planning of individuals and businesses and increase the efficiency of our economy.

Last August, the governor of the Bank of Canada Mr. Mark Carney said: “The single most direct contribution that monetary policy can make to sound economic performance is to provide our citizens with confidence that their money will retain its purchasing power.”

A 0% inflation target would achieve precisely this and send a powerful message that inflation in itself is wrong. That debasing the currency may bring some short-term gain but always brings long-term pain.

This would be a big step in the right direction.

I may be a dreamer, but I think monetary economics should be a hot topic! The current review of the Bank’s inflation target is a great time to have this kind of debate. I hope that more Canadians will become interested in in how the inflation rate target affects our purchasing power, our standard of living and therefore our life.

Thank you.

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This is the first article, speech, blog, anything, I have seen in Canada ever addressing what should be a huge issue.

Thank you

Jeff says :
8 June 2010 13:24

Absolutely excellent!
Well thought out and delivered, lets get the debate going in high-gear. It is imperative for all Canadians to re-visit and re-learn about “honest money”. Of course this topic has its simple and complex parts, hence the need for much discussion. One of the most fundamental and core relationships between ALL peoples of ALL walks of life, is their “commercial” relationship, and for any society to prosper and be at peace, this core relationship must be as fair and transparent as possible.
Thank you for Mr. Bernier for “dreaming” and dreaming big.
Jeffrey
ps another serious writer/thinker along these lines is billionaire Hugo Salina Price of Mexico, he has some excellent research on a pragmatic approach for reintroducing gold and silver as honest money to our “so called” sophisticated digitized economies.
check out http://www.plata.com.mx/mplata/articulos/articles.asp

Maybe the text I read, and re-read, in english is clearer than the french text dissected by l’Engagé … but I was well able to follow the logic of the argument presented and find that it is once again a common sense explanation of what could be an intimidating subject.

Thank you Mr. Bernier for putting this discussion into terms that most people can understand. I agree that it is a subject that should be discussed and understood by ordinary people such as myself who are concerned with personal and collective security.

It’s our money that is being artificially manipulated and adjusted and we must be aware of the consequences of every actions taken, as it has a very real effect on every aspect of our lives. Merci.

JO says :
8 June 2010 18:29

Mr. Bernier, MP

Just want to say thanks for this most excellent article. You show tremendous knowledge on this critical subject. Please spread the word as much as possible. You appear to lean on Austrian principles as I do. As someone who has spent my entire career in financial services in retail banking and compliance positions, i can tell you i am even more worried about the global economy now than I was in 07. Having spent about 2 hours / day following the economy/markets almost everyday since the age of 12, I have not been as scared as I am now. I am no perma bear either ! The foundation of the economy is rotten…most of what people percieve as the value of assets/incomes has been grossly inflated thanks to the build up of the greatest mountain of debt the world has ever seen. Unfortunately, most contracts are based on nominal/stated values. It is concerning to envision, in 2013-2020, the average homeBUYER (not homeowner) of 03/04 onward facing a home that is probably 30 % below what they paid with a copy of the renewal letter from the bank which could offer a renewal that will increase the monthly by hundreds of dollars/month…all in all, this has the makings of a major economic catastrophe. The use of heavily subsidized mortgages (CMHC of course!), artificially low rates, and other interventionist tactics to inflate a debt bubble using, of all things, our homes is a cruel joke on most citizens..a scheme which will make Madoff’s farce seem like child’s play..maybe you can do more on how CMHC/NHA policy distorted our economy sometime. As i say, all great credit inflations are a fraud on the people. Anyone with a grade 8 math class can see where the system ends as the rate of debt/money exceeds GDP consistently and signficantly. To make matters worse,the sudden austerity religion making the rounds and being implemented in large areas of the world seems to make another deep recession all but inevitable. Many countries do have major structural issues and a history excessive debt/spending, but i hope we never get forced into austerity to bail out bad trades at the banks. What a fraud.

That said, at the most fundamental level,monetary policy is a root cause of our current and future economic malaise. Government interference/manipulation of markets always ends in tears. It always encourages bad behaviour and poor decisions. I find it galling that Governor Carney and Mr. Flaherty make these comments about “maintaining confidence” in our money and “preventing housing bubbles” yet take actions which do nothing but create more wealth destruction. What do you expect with people who allow banks to run the greatest debt counterfeiting operation ever seen (kee 6-7 cents in real money on hand and magically create $ 1 in interest earning debt – what a system !), and who purposely target the prudent by holding short term rates below the rate of inflation (in my view, i look at it as net growth of money/credit, not CPI – in the US, they have rising real rates I would argue, we should be there in Canada within 24 months).

Anyway, keep up the good work.

Cheers
JO

Frank says :
8 June 2010 22:18

Once again, you are spot on. This really should be a hot topic among Canadians and we have the opportunity to be world leaders in setting monetary policy – setting an example of common sense and of free market prosperity, unhindered by state manipulation. Keep going Mr. Bernier, keep going!

Roy Eappen says :
9 June 2010 06:29

Always interested in what you have to say Maxime. Thanks for speaking out.

Yes, as I mention on my own blog, Mr. Bernier appears to be a disciple of the Austrian School of Economics, and a rather independent-minded member of a party that is often accused of not allowing independence of thought. In that regard, well done!

Shawn says :
9 June 2010 15:24

I’m incredibly impressed to see this pressing issue being discussed at all by anyone in government.

Now that I think about that statement, though, I think that’s particularly telling about the current state of politics.

In any case, I would suggest that there is generally a correlation between government overspending and monetary inflation, so maybe eliminating the budget deficit would be a good start?

Adam Smith says :
9 June 2010 16:11

Inflation, the Underrated Destroyer of Prosperity

How refreshing to have a Canadian conservative MP Maxime Bernier talking of the central bank manipulating interest rates.

To say that if the money supply does not grow more the economy will not grow is insanity.
How about making your self a nice garden and my job will be to print paper and act as a consumer.
I will ask you to give me your production in exchange for nothing.

Lets call this a stimulus package.

MR Bernier you don’t have to go back in history suggesting Gold. It was not much better.
The Romans use to debase Gold until it was 1% of its original valuation.
Money can only be a claim on goods otherwise we are being cheated. What they are doing is conveniently called “Quantitative Easing” so that most people do not understand that it is counterfeiting.

So called “Inflation target” could just as well be called “the cheating target”. It’s the amount of valueless money in circulation above the preceding period.I do no agree with Maxime on a gold standard since we do not need to have a medium with an intrinsic valuation. We are not buying gold when we trade goods; we are buying the production unit(s) that the underlying medium represents. I realize the argument that Central banks can not print gold but Gold would be a non necessary additional cost and a waste of human energy.

If I trade an equal value of milk against orange juice why should anyone dig for Gold to make this trade hapen?

An honest medium will do just fine.
Should Africa suddenly find a huge amounts of gold,would it make sense that suddenly it would become one of the richest country in the world with one of the smallest GDP excluding Gold?

However,Maxime is definitively on to something. We need a new independent way to stop the issuing of excess currency over and above the real productivity and as far away from the corrupt political agendas.

Lets face it the only reason Governments love inflation is because they can pay the so called public debt in the future with a devaluated currency.

Politician’s can purchase vote, talk about stimulus, subsidies for malinvestment, talk of changes and miracles all day long but at the end of the day there is no free lunch.

A) We will soon pay and they will postpone and cut the free ride or:
B) We will get more devaluation (the invisible taxation)which they will love to call price increase.

Guess what they will choose.

Maxime keep it up you are getting closer.

Bruce Annan says :
9 June 2010 16:17

Amen, and thank you again for your courage. I am amused each month by the StatsCan “core inflation rate”, which sets aside the price of food, energy and other things people actually have to buy to tell us “all is well”.

Rub my eyes…. I had to re-read your blog Mr Bernier . I did not think there were any Canadians in parliament who believed in the Austrian economic philosophy . What a refreshing read. There is some hope for Canada. I hope you can teach other members of Parlament ( and Carney ) real economics before the Keynesian model Canada and G20 practice reaches its final chapters and destroys our country. I also follow Mark Faber, Peter Schiff and family, Ron Paul, The works published at mises.org , Jim Rogers to name a few. I now have you bookmarked and will study . Thumbs Up ^ . Looking Fwd to your next post.

I didn’t think we had a single MP in Canada that was honest and that really cared about our economy. Maxime, you could make me switch to a Conservative voter if you replace Harper. The Financial Post is doing a great job getting your opinions out there. Keep at it! This country NEEDS you and more like you!!!

David W. Lincoln says :
11 June 2010 22:32

Given that Andrew Coyne came out swinging against this speech on Thursday’s “At Issue” panel, might I suggest that this speech stands on the shoulders of various predecessors. This way, the fight isn’t just Maxime, and allies, going on offense, but Maxime standing on the shoulders of the Austrian school of economics (as communicated in “75 years of funny money” and “Keynesian Contagion”, both of which appeared in the Financial Post) plus allies.

Keep it up, Maxime, and frankly as long as there are allies who are communicating what you communicate, directing attention to them would appear to be the mark of a statesman. After all, why the need to reinvent the wheel? As long as what is said is the truth, does it really matter who says it?

M says :
12 June 2010 00:44

99% of the time, I’ve only heard politicians talk about how to spend money. This is the first time I’ve ever heard any politician in Canada talk about economics in a way that made sense.

I sincerely hope this man is running for the Prime Minister’s position some day. I have never heard of him before. But I shall memorize his name and try to keep track of him & his efforts in getting his message out.

I hope he writes a book on his ideas explaining the situation just as he did in his speach. Unfortunately very few people even understand anything about central banking, fiat money and how this racket works.. and where its going to lead us all eventually. I suspect its in the interest of those running the system to have nobody understand how the system works.